Home Bias in Banks’ Sovereign Debt Holdings and Fiscal Sustainability

Abstract

Concerns about fiscal sustainability and worsening balance sheet conditions of major banks triggered a doom loop between banks and sovereigns during the European sovereign debt crisis. Despite closer financial integration and additional institutional safeguards, the home bias, i.e. bank holdings of domestic sovereign debt, is still high in most EU countries. We examine the non-linear effects of home bias on fiscal sustainability using panel smooth transition regression models on a fiscal rule for EU countries. We find that debt consolidation is a concern for governments. Potential financial instability constrains governments’ deficit bias, without endangering economic stabilisation, at least in countries with developed financial markets. Countries with shallow markets face constraints in stabilisation of economic shocks and must run procyclical policies to avoid debt problems. Foreign entry in the banking system disciplines sovereigns, yet state-owned banks soften budget constraints.

Keywords: fiscal policy, sovereign debt, debt sustainability, home bias, financial development, sovereign-bank nexus, doom loop.